Inheriting an IRA? Here's how to play by the rules.

Q: What are the tax consequences of inheriting an IRA? Do I have to keep the money in an IRA? If so, do I need to open a new IRA to hold it, or can I roll it into an existing IRA?
D.G., Washington, D.C.

A: The consequences depend upon whether you are a spousal beneficiary or if you are a beneficiary other than a spouse. Here's a brief rundown on a rather complicated topic, provided by St. Cloud, Minn.-based certified public accountant Dave Hinnenkamp:

Inherited from a spouse – A traditional IRA inherited from a deceased spouse can be rolled into another traditional IRA established in your name, or you can choose to treat the inherited IRA as your own by rolling the inherited IRA into your existing IRA. As a result, you can delay the recognition of income until you (the surviving spouse) reach age 70-1/2. At that time, you must begin taking Required Minimum Distributions (RMD). The amount you must take is based on RMD tables established by the IRS.

Inherited from someone other than a spouse – In this case, you cannot roll the account into your IRA since this would result in immediate recognition of taxable income on the entire value of the inherited IRA. If the previous IRA owner died prior to beginning distributions, the following rules will generally apply:

Rule No. 1 – The IRA must be distributed by Dec. 31 of the fifth year following the owner's death.

Rule No. 2 – The IRA must be distributed over the life expectancy of the designated beneficiary (again, see appropriate IRS tables).

The terms of the IRA adoption agreement can specify which of the rules apply, or they can allow the beneficiary to determine which rule to follow.

This choice must generally be made by Dec. 31 of the year following the year of the owner's death. Rule No. 2 generally allows for the greater tax deferral, assuming the beneficiary's life expectancy is greater than five years.

Q: Are Canadian royalty trusts a good investment?
J.G., via e-mail

A: In October, Canadian Finance Minister Jim Flaherty proposed phasing out certain tax advantages of Canadian trusts. This was a totally unexpected move, says W. Thomas Curtis, a CPA and certified financial planner in Gaithersburg, Md., and it has shaken Canadian financial markets as they try to gauge the impact. Consequently, prices of the shares the trusts issue – they're traded just like stocks on Canadian exchanges, and many can be bought by Americans – have generally fallen as a result.

Among the many types of trusts affected are oil and gas trusts, energy service trusts, electric power trusts, real estate investment trusts, and business trusts. They pay out much of their income as royalties, so investors favor them for the stream of income they can produce.

Under current Canadian law, they avoid taxes at the corporate level. But the new proposal would impose taxes, though existing trusts will be exempt from taxation until 2011. New trusts will be subject to the new tax upon their creation.

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